The Debt Bomb 2.0

A Tomorrow’s World article last year warned that trillion-dollar budget deficits run up by the United States government are accumulating into an unsustainable “debt bomb” that will eventually explode to the detriment of the nation. A recent Wall Street Journal article has now warned of the same “debt bomb”—as the crisis Tomorrow’s World described last year is growing even worse!

In 2012, total U.S. debt is expected to reach $11.58 trillion—up from a “mere” $3.8 trillion in 1997. About half is held outside the United States. A $1.2 trillion deficit is projected for 2012, continuing the dangerous trend.

What some do not realize is that these huge deficits contain another “explosive” feature. The overall impact of the total debt on the U.S. economy and credit rating is also affected by interest rates. Call it “The Debt Bomb 2.0.”

Remember that the interest cost of debt at 4 percent is twice the cost at 2 percent. Federal Reserve policy has kept short-term borrowing costs near zero in recent years, and the annual rate on the benchmark 10-year Treasury bond has been under 2 percent, keeping the total costs of borrowing abnormally low. But the situation is changing rapidly. The Obama administration hoped to “jump start” the U.S. economy through deficit spending, which has proved in the past to be inflationary. So, as the economy has improved, inflation has been edging up, forcing investors to demand higher interest rates on long-term bonds.

In the last six months of 2011, annualized U.S. inflation averaged around 3.5 percent. This means that an investor who bought a ten-year Treasury bond yielding 2 percent could be facing a true yield of negative 1.5 percent—the difference between the bond yield and the inflation rate.

This could not last long. On March 12, ten-year Treasury bonds were yielding 2.03 percent. By March 16, they had leaped to 2.31 percent, a huge increase. Is this a trend? The Congressional Budget Office thinks so. The Wall Street Journal reported that, for the years 2013–2017, “CBO expects average rates on 10-year Treasury notes to climb to 3.8 percent” (“Uncle Sam’s Teaser Rate,” p. A14). That is nearly double the current rate, and would nearly double the interest cost of new debt. Yet the CBO may be making a rosy assessment of the situation.

Are existing low rates “locked in” for a long time? No! The Wall Street Journal also reported, “Today, 52 percent of the debt is due within three years” (ibid.). This means that trillions of dollars in debt will need to be refinanced at higher rates, adding huge sums to the existing deficit. Also from the article: “Low interest rates disguise the federal debt bomb… During the 1990’s the average [overall federal interest rate] was well above 6 percent... If Uncle Sam had to pay 6 percent on its [current] debt the annual interest payments of $642 billion would surpass total federal spending on Medicare… Such a radical change in budget math could trigger a political panic…” The election campaigns will likely make an issue of “this fiscal nitroglycerin that Mr. Obama and Fed Chairman Ben Bernanke have created… The next Presidential term may be spent trying to defuse the Obama debt bomb” (ibid.).

That is, if the debt bomb does not explode first. Our July-August 2011 Tomorrow’s Worldarticle noted a warning by Bank of International Settlements (BIS) economists, “that the U.S. could be approaching a ‘tipping point’ in which interest on debt exceeds economic growth, forcing a spiral of more borrowing and deficits. This occurs around the point where government debt exceeds the gross domestic product—exactly where the U.S. is today. The BIS also warned that on the downside of the tipping point, interest rates can spike ‘sharply and suddenly,’ exacerbating the problem and accelerating the downward slide. This could be triggered by a downgrading of U.S. sovereign debt.”